[BETA] Fortnightly

Is a proposed solution to energy-trading woes too little too late?

The Committee of Chief Risk Officers (CCRO) representing various utilities and merchant energy companies, recently released a set of detailed guidelines to improve the image and overall practices of energy trading, but the effort misses the mark.

First, these guidelines are voluntary not mandatory, with no teeth to ensure compliance, policing, or remedy for non-compliance. The proposal appears to be more of an attempt by the 31 participants to demonstrate they can regulate themselves and avoid oversight by a less than sympathetic third party. But as recent accounting scandals have shown, self-regulation without independent oversight does not work.

Secondly, the CCRO proposal does not address one of the primary gray areas that helped to fuel the recent industrywide meltdown. Mainly, how should energy companies account for off-balance-sheet transactions, including reporting and mark-to-market practices, especially in instances when there is no observable price and low to no liquidity?

The guidelines also fail to define and adequately address what the appropriate risk reserves should be against estimated transaction values. Such reserve "best practices" could set a standard for conservatism when taking reserves for anticipated and unforeseen risk, such as market and credit risk. This is an important area because many energy industry transactions are off-balance-sheet (e.g., long-dated (10- to 20-year) tolling agreements and operating leases).

Critical Issues

The CCRO proposal does not address how to mark-to-market long-dated transactions and how much of non-current and non-cash income should be booked as current profit. Should it be 25 percent? Fifty percent? Seventy-five percent? Or more? Enron thought it should be 100 to 150 percent. And if a market price is not available, how should models be applied when marking the overall trading book to market?

Also, which model(s) and types of standardized assumptions (e.g., price volatilities and correlations) should be used when applying pricing and risk measurement models? As learned with long-term capital management, models and assumptions can and will be precisely wrong.

Additionally, although certain members who crafted this proposal have previously admitted providing false pricing data for industrywide indexes, the current CCRO proposal does not address this clear industry weakness. This is a missed opportunity to swiftly address a serious issue that continues to undermine overall industry creditability.

Although industrywide reporting, standardization, and consistency is a good thing, the CCRO recommendations do very little to solve the industry's current woes. This proposal attempts to address longer-term issues while most major energy trading and merchant companies have lost large quantities of blood and are fighting for their lives. How will the guidelines resuscitate Dynegy, El Paso, NRG, NEG, Calpine, or Williams?

The Evolution of Energy Markets: A New Model Emerges

If the new CCRO proposal will not fix the current energy trading industry woes, what will? To answer this question, it is important to identify the main underlying trend in the industry.

The new energy-trading model, which is rapidly evolving, will not remotely resemble the wholesale model, which has been the norm over the previous six years. Unregulated wholesale energy trading the way Dynegy,